Saturday, May 05, 2007

The "Me" Generation Cashes Out

Well-known Internet business columnist Robert Cringley writes yesterday about IBM's rumored layoffs, expected to potentially reach nearly half the company at 155,000 workers. Such a shedding of domestic employees would certainly have a significant impact on the U.S. economy, but would deliver significant short-term compensation to the executives of the firm. Implicit in IBM's plans are massive outsourcing of domestic technology functions to foreign firms in China, India and other lower-cost locations. If successful, the move would transition the firm to being little more than a domestic holding company of outsourced contracts. IBM's era of innovation would be over, but for the firm's retiring managers, the one-time payout would be exceptional.

Recently, leveraged buyout activities converting Fortune 500 public firms to privately held assets at the expense of firm cashflow and intellectual capital have escalated to new heights. With the carrot of a one-time gift of a few dollars per share, LBO firms obtain ownership of their targets financed by cashflows that a more visionary executive would be directing into innovation. Most of the LBOs I've analyzed have some interesting characteristics:
  • Retiring senior executives seeking a massive cash pay-out that normal retirement options do not provide.
  • Healthy cashflows that have been wasted by the senior management's lack of interest in the "next 20 years" and instead make the company a huge LBO target. That many LBO events occur with the full participation of senior management in companies with excess, under-utilized cashflow is no mistake.
  • Stock prices that are undervalued for the cashflows in an economy that continues to value excitement (e.g. Goggle) or short-term gains over long-term strategy and fundamentals.
In a sense, it appears that there is little agency theory conflict between the actions of these retiring baby boomer executives and the shareholders they represent. Wall Street has championed the short-term view and long-term benefits (such as the open source efforts of IBM) really have no value to institutional investors. In the case of the LBO, shareholders get a one-time premium per share over the apparent equilibrium price prior to the LBO announcement, executive management gets a hefty retirement package and the new owners get massive cashflows to finance their own ambitions. As more executive boomers retire, more firms are subject to the retirement enrichment goals of their executives, delivering short-term, one-time cash gifts to the eager shareholders.

Given that everyone seems to be sharing in the massive cashing-out of U.S. productive infrastructure, where's the problem with this cash party? Unfortunately, when a firm gives away its core competencies to foreign firms for a little cash, little remains other than short-term returns. In a sense, retiring executives are pawning the intellectual capital developed over 150 years of U.S. industrial effort for personal riches and a few dollars to coerce the shareholders into supporting these efforts. For the early movers, it certainly is a lucrative strategy, as Chinese, Indian, Malaysian and other developing market firms appear to overpay for the opportunity to assume U.S. operations and commensurate know-how. A few billion dollars invested bypasses 50 or more years of economic struggle, guaranteeing both advancement in operational knowledge and cashflows to sustain the growth from the U.S. firm that is liquidating its productive capacity.

However, this portrays a grim future for U.S. mid and large cap firms. Consider what the S&P 500 will look like in 20 years, having liquidated all of its manufacturing, innovation and production operations. Forget about sustaining an information economy, as sectors other than entertainment*, healthcare, pharmaceuticals*, utilities, corporate agriculture and professional services (mostly legal and financial) will no longer have any domestic function. Domestic production outside of the agricultural sector will cease. Worse yet, automation of much of the agricultural sector and continued support by both political parties for low-cost immigrant labor for that which isn't automated leaves little employment opportunity. Lacking any sector to serve as an engine for the domestic economy, the long-term prognosis isn't optimistic.

For the "Me Generation" boomers, the cash-out is exceptional as it not only liquidates their improvements, but those of the predecessor generations. Worse yet, this generation has seen it fit to assume excessive long-term foreign debt to provide for low-cost prescription drugs (which they are most capable as a demographic in paying for), have poured trillions into ineffective social programs consistent with the counter-culture philosophies of their youth and rung up unsustainable foreign-financed Federal and trade debt to sustain their lifestyles. While those of the great generation would certainly be horrified that their children are pawning the product of their efforts for mega-sized second homes in Palm Springs, the boomers are fortunate to be mostly immune from their criticism.

So what's left for a liquidated economy? It'll be interesting to see what sectors survive. Younger generations still possess creative ability, but have been impaired in mid-to-large cap firms with the glut of senior-level boomers who've yet to retire. Certainly, some of the larger firms might be salvageable and some of their intellectual capital restored. Overall, it is most likely that if the economy is to recover its productive capital, this development will emerge from today's small to micro-cap firms. Once leveraged to the hilt in debt and having seen its intellectual capital sold off oversees for pennies on its true value, today's S&P 500 is unlikely to have much value in the long-run.

* Even these sectors are seriously threatened by emerging economies that refuse to recognize the intellectual property laws that provide for return on investment in entertainment and medical innovation, as Thailand and Brazil have recently shown us. Even U.S. energy firms aren't immune from this risk as foreign markets like Venezuela and Ecuador refuse to recognize property rights and seek to capture the financial returns for themselves.

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